Question

1. A company faces a choice between using straight line or accelerated depreciation in preparing the capital budget for a major expansion project. The project will last four years and require a $1.7 million investment in new equipment. Under the straight-line method, this expense would be spread evenly over the four-year life of the project. Applicable MACRS depreciation rates are 33.33%, 44.45%, 14.8%, and 7.41%. The company’s WACC is 10% and the tax rate is 40%.

1. What is the depreciation expense for each year under the two methods?

2. What is the NPV of the project under each method?

3. How would managers prefer to account for expenses if their bonus plan uses EPS to calculate bonus payouts?

Answer 1

Please note the solution :

a) Depreciation Expense

Year	Straight Line	Accelerated Method
1	=1700000 / 4 = 425000	= 1700000 * 33.33% =566610
2	425000	= 1700000 * 44.45% = 755650
3	425000	= 1700000 * 14.8% = 251600
4	425000	= 1700000 * 7.41% = 125970

b) NPV Calculation

> Straight line method

Particulars	Year 1	Year 2	Year 3	Year 4
Depreciation	425000	425000	425000	425000
Tax savings @ 40%	170000	170000	170000	170000
PV @ 10%	154545.45	140495.87	127723.52	116112.29

Total Savings = 538877.13

> Accelerated Depreciation method

Particulars	Year 1	Year 2	Year 3	Year 4
Depreciation	566610	755650	251600	125970
Tax savings @ 40%	226644	302260	100640	50388
PV @ 10%	206040	249801.65	75612.32	34415.68

Tax savings = 565869.66

> NPV

Particulars	Method 1	Method 2
Tax savings	538877.13	565869.66
Equipment cost	1700000	1700000
NPV	-1161122.87	-1134130.34

Note : Since no information regarding the revenue and cost is provided in question, NPV is calculated using the equipment cost and tax savings due to depreciation.

c) If the bonus payout depends upon the Earnings per share then the managers would prefer straight line depreciation. It is because in straight line depreciation, expense remain same for each year. Thus, impact on earnings will remain same in each year and hence their bonus will remain steady each year.

Whereas in accelerated depreciation method, expense charge for each year changes. Like in our question, for first 2 years, depreciation charge is more than 75 % and in remaining year balance charge is made. Thus, earnings will changes due to accelerated depreciation method and hence bonus also.